Should Small Businesses Incorporate or Stay a Sole Proprietorship?

Starting a new business is all about flexibility. You have the chance to set your own hours, be your own boss, and spent time and energy doing work you are truly passionate about each day. An added area of flexibility is choosing an entity formation.

Most small businesses start off as a default entity known as a sole proprietorship. Some entrepreneurs may enjoy being sole proprietors and exercising control over their business. They may choose to keep this entity formation.

Small business owner working on incorporation paperwork

However, a sole proprietorship is also considered to be an unincorporated entity. It is one of the few business entities that does not provide limited liability protection. Limited liability protection is a key benefit in forming an incorporated business.

If you’re wondering whether to stay a sole proprietorship or incorporate your business, consider a few of these factors.

Sole proprietors are held fully responsible for the business

The owner of a sole proprietor is the boss. There are no other partners, or members, associated with the business. As such, they may be able to make decisions as they see fit and run the company on their own terms.

However, there is a catch that comes with being your own boss. A sole proprietor is held responsible for good things that happen to the business — as well as bad things. From a customer accidentally getting injured in your storefront and serving you with a lawsuit to struggling to pay off accumulating business debt, there are several liabilities that may negatively impact both the business and its owner.

Incorporating provides limited liability protection

Constantly considering the “what ifs?” in the event of a precarious situation is often not ideal for entrepreneurs. Starting a business is hard work and it’s important to maintain peace of mind. Some sole proprietors may find it’s a bit more advantageous if they incorporate or form a limited liability company (LLC).

Incorporated businesses, including LLCs, provide business owners with limited liability. This creates a separation between professional and personal assets. Limited liability protects the owner’s personal assets, including houses and cars, in the event of an incident occurring that may be considered a liability for your business.

photo credit: Simon Holland / Flickr

Even more benefits come with incorporation

Limited liability aside, incorporating a business gives business owners even more much-needed benefits to successfully run their companies. Some of these include, but are not limited to, the following:

Tax benefits

This is often one of the most popular benefits to incorporating or forming an LLC. Incorporated businesses have the ability to be taxed as a pass-through entity formation. If they are not already this formation, they may elect a pass-through entity such as an S Corporation. Sole proprietors, on the other hand, are also responsible for reporting all income on their tax returns. They must pay personal and business tax, which can often make for an expensive tax bill.

Draft an agreement

Incorporated businesses, such as LLCs, may be run by multiple members. You may decide if you wish to be organized as a member manager LLC or manager managed LLC and draft an operating agreement that states the roles and responsibilities of each member. This type of agreement cannot be drafted as a sole proprietor, who generally runs the business on their own terms.

Forming a specialized entity formation

Entrepreneurs in specialized professions, including lawyers and physicians, may choose to incorporate as a professional corporation (PC) or a professional limited liability company (PLLC). Entrepreneurs that form this entity formation may be able to limit personal liability for claims related to the errors or malpractice of a partner. A sole proprietor in a licensed profession, like an accountant, or architect, may consider this type of incorporation for their business.

Should I incorporate or stay a sole proprietor?

Now that you have a good understanding of what sole proprietors are responsible for as well as the benefits of incorporation, it’s time to make a decision for your small business.

However, we cannot personally tell you which option is best for your business. Every business has different, unique needs. Reach out to a legal professional for extra guidance and to answer any questions you may have about the process of incorporating as a different entity or remaining a sole proprietor.